TMFMmbop (37.11)

Short This Stock

6

It’s Thursday morning and that means it’s time for our next idea in the CAPS Champion of the World Contest. But before I get to that, I'd be remiss if I didn't point out that we have a brand new issue of Motley Fool Global Gainsreleasing at noon today. It includes two new picks (picks that this year are beating the market by 25 percentage points on average), a wildcard resource play, and an update on our global asset allocation strategy.

ThesisThere has been a lot of crying in the business press about the animal spirits being wrung out of the market by the collapse of the credit market. Sure some of the speculative nature has subsided, but I offer up China BAK Battery as proof that speculative spirits are still alive and well in pockets of the market. With its history of losing money, cash consumption, and a very weak balance sheet the only reason China BAK is up 300-some-odd percent from its lows are the huge expectations investors have for the company.

But I think there’s a very good chance that China BAK will need to tap what’s left of its credit line or issue additional shares to survive...making it a great short for our CAPS contest.

Company descriptionChina BAK is a battery manufacturer based in Shenzhen. Its batteries are used it laptops, netbooks, mp3 players, phones, and other electronic devices. Given what seems like constant demand for the newest electronic devices (full disclosure: I love my kindle) and China’s low-cost manufacturing you might think it’s not such a bad business to be in. Unfortunately for China BAK, batteries are commodities and that means it faces competition from bigger companies like Sony (SNE) and lower cost competitors such as Berkshire Hathaway (BRK-A) investment BYD Company (BYDDY.PK).

ValuationChina BAK is expensive in comparison to BYD too. BYD is currently riding high on its investment and endorsement from Berkshire Hathaway, but it’s only a 3-star stock in CAPS (to China BAK’s 4) and trades at a slightly lower EV/EBITDA multiple of 23 compared to China BAK’s 24. Unlike BYD, China BAK has never generated free cash flow, doesn’t have a good record of operating profits, and hasn't gotten a stamp of approval for the world's smartest investment team.

The biggest problem though is the combination of negative cash flow and a small cash balance. Over the last two years China BAK has overcome its lack of cash flow by taking on more debt and issuing shares. With just $25 million in cash left and a cash burn rate well in excess of that for each of the last three years it’s likely that China BAK will be issuing equity or tapping the remaining $75 million in its credit line in short order.

Either one of those events would trigger a downward reassessment by the market, so put a red thumb on this one and wait for the points to roll in.

I believe that this calls for short pants. Stay out of the troubling waters. Just don't step in too deep.

This is not the world’s only battery company.

Most impressive competitor is BYD. And as we all know Berkshire Hathaway has been investing with BYD with deep pockets and BYD has shown positive free cash flow. Would the all knowing sooth sayer put up with any thing less?

The Chinese government has allegedly been known recently of propping stock prices of some stocks.

Two years running negative cash flow, CBAK had to issue stock and take on debt. Very little of cash left means more debt or more stock issue or both. Or the economy jumps and CBAK is the only one to have the new whisles in town. But even then they have had problems controling operating profits. I guess that is kinda important.

The batteries manufactured are for small items, laptops, mp3, phones and etc. If the limited market and the economy is slow to pick up and big inventories all will hurt sales.

The mania surrounding this stock will keep it on top. Where have I heard that before (C)(GM)(CSIQ)

But as we found out with Berkshire running from some Russian stocks when the going got rough (oil), all these predictions are out the window. Will the Chinese government act the same way? I don't think so. Everyone owes the Chinese money and there doesn't seem to be that negative element within the Chinese government as in the Russian government (allegedly). Will the Chinese government stand against Berkshire? Oh yes, but not as hard as any other company or some countries. Will they come down hard on the company (CBAK)? Absolutely! If this starts to happen start thinking about going long.

Will the Chinese government allow Private Equity to step in? Come on I mean really.

Most of this information comes from TMFMmbop' blog along with information from YAHOO and MSN. And some of my dreams, they talk to me you know even if I don't carry my blanket with me all the time. (movie reference)